Question

What are the limitations of duration and convexity? Suggest ways that can mitigated or overcome the limitation(s). How do they work?

Answer 1

Duration is the approximate sensitivity of a bond’s price to interest rate changes. It is used as a measure of interest rate sensitivity.

Convexity measures the change in yield sensitivity. It defines as a change in the duration of bond for a given change in its yield.

Duration measures the approximate sensitivity of the value of the bond to the change in interest rate. Convexity is another measure of the change in price.

Limitations-

1.  Duration vulnerable to reinvestment risk and measures only the magnitude of severity of the given yield change and not its probability.

2. Duration works only for small changes in the yield. It is not a complete measure of bond risk

3. Duration calculations expresses identical yield change for all bonds in a portfolio.

4. Duration does not capture the convexity of the bond on its price performance when yields change by more than a small amount.

5. Duration does not account accurately for large changes in the interest rates.

6. Duration only measures the linear relationship between the price and the yield of the bond.

7. The convexity measures provides a second approximation. Convexity takes off where duration stops in a sense that it gives a more accurate price of a bond based on interest rate changes than Duration.

The ways that can mitigated or overcome the limitations-

1. Duration and convexity are two tools used to manage the interest risk exposure. There are tools such as Using a gap management tools to equate the durations of assets and liabilities.

2. Understanding Opportunity Risk

3. Mitigated through various hedging strategies.

4. Adjusting the portfolio’s average duration to coincide with the forecast.